Big Banks Deciding The Fates Of Troubled Subprime Lenders

SAN FRANCISCO (Market Watch) -- A credit crunch in the market for low-end mortgages has left companies specializing in these subprime loans at the mercy of big banks like Merrill Lynch & Co. and J.P. Morgan Chase.

Several private subprime lenders, such as Ownit Mortgage Solutions, Mortgage Lenders Network USA and ResMAE Mortgage Corp., have already filed for bankruptcy protection after having financial lifelines cut by Merrill and other big banks.

The fate of other publicly traded subprime specialists, such as New Century, Novastar Financial and Fieldstone Investment, may also rest in the hands of big banks that have helped finance their recent rapid expansion, analysts said.

Subprime mortgages are offered to homebuyers who fail to meet the strictest lending standards. While these loans remain a small part of the home lending industry, they've helped more people buy homes who previously couldn't afford it, helping to fuel a surge in housing prices in 2004 and 2005.

That's why the credit crunch in the subprime market is being so closely watched by investors, economists and policymakers. By cutting off access to credit for these extra buyers, demand for homes may fall further, depressing prices and fueling a broader slowdown in the U.S. housing market.

"This distress in the subprime area is a significant concern," Ben Bernanke said on Wednesday. While noting that the contraction has yet to reach a point where it will affect overall economic expansion, the Federal Reserve chairman said he's monitoring developments.

"There are some loans that have been made that are not turning out well, and to the detriment of both the lenders and the borrowers," he said. "We will certainly be watching that carefully and trying to provide guidance and oversight to minimize that risk going forward."

Lifelines
Most subprime specialists sell the loans they've originated to big banks, which then package them up and sell them on again as mortgage-backed securities to hedge funds and other institutional investors.

It usually takes at least several weeks for subprime specialists to sell their loans. During that time, big banks provide a "warehouse" in which to store them. In return for passing the loan onto these warehouse lenders, the originators get cash equal to the value of the asset, minus a fee, called a "haircut", which provides a cushion against late payments and delinquencies.

The warehouse banks, such as Merrill. J.P. Morgan Chase, Citigroup and Bank of America, are crucial to this process because they keep subprime lenders supplied with enough cash to help them make more loans immediately.

But as more subprime borrowers struggle to meet their monthly mortgage payments, cracks have begun to form in this system.

Warehouse lenders have started worrying about the quality of subprime loans that have been originated in recent years. Some are now asking subprime specialists for bigger haircuts, putting the originators in financial peril and forcing some into bankruptcy.

"Warehouse lenders are the lifelines for a lot of these subprime originators because they don't have the financial capacity to fund these loans by themselves," Ernie Napier, head of the specialty finance team at rating agency Standard & Poor's, said. "To the extent that these warehouse lenders go away, the whole process starts to unravel."

Pulling the plug
Mortgage Lenders Network USA, the 15th largest subprime company in the U.S., filed for bankruptcy protection this month.

As more borrowers defaulted early on the company's loans at the end of 2006, it tightened lending standards. It also introduced a new product, but mispriced it. After making at least $600 million in new loans with this product, Mortgage Lenders Network had to sell them at a loss in the secondary market.

Some of the company's warehouse lenders, which included Merrill and Goldman Sachs, cut back their financing, forcing Mortgage Lenders Network to post more collateral. When it couldn't come up with the extra cash, some of these lenders refused to advance any more money and the company had to shut down, according to its bankruptcy filing.

"The impression was that the warehouse lenders put them up against the wall and then pulled the plug," S&P's Napier said.

Ownit, one of the fastest growing subprime originators which was partly owned by Merrill, filed for bankruptcy on Dec. 28.

In November, J.P. Morgan Chase, which had provided warehouse financing since late 2003, said it planned to shut down the facility by the middle of December. Merrill then made a margin call, sweeping up about $15 million of the company's cash, leaving it with roughly $7.4 million in liquid funds, according to Ownit's filing.

Later that month, J.P. Morgan Chase decided not to fund loans Ownit had recently made and froze the rest of its money, Ownit said. By Dec. 5, Ownit said it had to lay off most of its employees.

Mystery margin caller
In recent weeks, warnings from banking giant HSBC Holdings and New Century have shaken subprime confidence further, sparking speculation that a major bank is aggressively making margin calls.

Accredited Home Lenders has had to come up with more cash after getting margin calls from some of its warehouse lenders, Stuart Marvin, executive vice president at the subprime specialist told analysts during a conference call on Wednesday. See story on Accredited's recent results.

"We have eight different warehouse lenders; I would say the majority of them are acting very rationally," Marvin said. "There is one that is acting somewhat irrationally, although I won't mention them by name. We have migrated the fundings away from that warehouse lender to one of the other seven until they begin to act more rationally again."

Industry publication National Mortgage News said this week that Merrill Lynch has been making margins calls. A Merrill spokesman declined to comment.

In late January, J.P. Morgan Chief Executive Jamie Dimon noted rising defaults in some of its riskiest home loans and said the bank had largely exited the subprime business. See full story.

Repurchase redux
Big banks are clamping down on subprime specialists in other ways too.
When originators sell loans on to big banks, the buyers have the right to send them back in certain circumstances, including when borrowers fail to make payments during the first month or two. In those cases, the originator is forced to repurchase the loans.

Early payment defaults have jumped for subprime loans made in recent years, forcing higher-than-expected repurchases by originators like New Century, Fremont and Accredited.

Big repurchases can threaten the survival of subprime originators because they can struggle to come up with the extra cash needed to buy the loans back.

ResMAE Mortgage Corp., which had quickly become the 20th largest subprime specialist in the U.S., filed for bankruptcy this week and said it plans to sell most of its assets to Credit Suisse for $19 million. See full story.

By early 2005, loan originations began to wane, knocking ResMAE's profitability. By cutting costs and lifting the interest rates it charged on loans, the company said it was able to make a small profit last year "despite the industry collapsing around it."

But then Merrill Lynch, which had become the largest buyer of ResMAE's loans, asked the company to repurchase more than $300 million worth of loans. That "enormous" repurchase request, which ResMAE disputes, triggered a liquidity crisis and forced the company to put itself up for sale.

The repurchase demands "crippled ResMAE's operations by requiring the company to post enormous reserves, which dramatically reduced its capital and operating liquidity," the company said in its filing.

New Century, new problems
New Century shares lost more than a third of their value last week after the mortgage services provider slashed its forecast for loan production this year because early-payment defaults and loan repurchases have led to tighter underwriting guidelines. See full story.

The company said it has to restate most of its results from 2006 because of mistakes in how it accounted for losses on repurchased loans.

New Century got into trouble because its systems didn't predict the level of repurchases accurately enough, said Zack Gast, a financial sector analyst at the Center for Financial Research and Analysis (CFRA), a research firm.

The company was particularly aggressive in how it accounted for the cost of buying back loans, Gast explained.
The conservative approach is to set aside money based on the assumption that if forced to repurchase problem loans, originators will likely have to resell again them at a lower price, Gast said.

Instead, New Century only provisioned for the cost of repurchasing the loans. Once those assets were back on its balance sheet, the company recorded 100% of their value, Gast noted.

"The pool of loans sitting on their balance sheet has been valued at the wrong price," he concluded.
"Finance companies that go out of business usually do so because of a lack of liquidity," Bruce reminded his clients ominously.

New Century has financing agreements with lots of large banks including Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Morgan Stanley, UBS AG and Goldman.

The contracts include covenants requiring New Century to maintain minimum levels of liquidity and debt levels. If those are breached, the lenders can terminate the agreements and demand their money back immediately.

New Century is currently required to keep liquidity levels to at least $134.4 million, according to its latest quarterly results filing with the Securities and Exchange Commission. The company said last week that it had cash and liquidity in excess of $350 million at the end of 2006.

Who's next?
After the warnings from New Century and HSBC, warehouse lenders are probably now deciding which subprime originators to continue backing and which ones to drop, CFRA's Gast said.

"If all lenders increase their margin requirements that would probably result in bankruptcy," he said. "If you can't come up with the extra cash, then the warehouse lenders will step in and shut you down."

But which other subprime specialists are in peril?
Gast said that depends partly on companies' liquidity and how aggressive they've been in accounting for repurchased loans.

"In the current liquidity environment, CFRA does not believe any lender is at low risk," he wrote. "All lenders are showing signs of credit quality deterioration."

Meltdown underway
Gast was also reluctant to say whether things will get worse for the subprime industry, or estimate when the situation might improve. However, other experts are concerned about the immediate future.

While most of Accredited's warehouse lenders have remained rational, Marvin suggested these big banks could take a tougher approach to rival subprime specialists with less liquidity.

"The long-awaited meltdown in subprime mortgage lending is now underway, and it likely has further to go," Richard Berner, chief U.S. economist at Morgan Stanley, wrote in a note to clients this week. "More subprime lenders may fold, and the supply of subprime credit likely will tighten further."

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